REIT Preferred Stocks: Attractive Yields But Limited Liquidity

By Michael Aneiro

With REITs issuing preferred stock at a record pace this year, Imperial Capital offers its take on this market, saying REIT preferreds can offer attractive yield multiples over regular REIT dividends but face risks including more limited liquidity.

Imperial says preferred stocks tend to appeal to investors seeking yield as well as to issuers as attractively priced capital, with the market traditionally dominated by retail investors with a buy-and-hold mentality. But Imperial sees a growing level of interest among institutions and believes their involvement will bring greater liquidity and price transparency to the secondary market.

Public REIT balance sheet liabilities usually comprise equity and debt, both secured and unsecured. According to Imperial, for REITs with outstanding preferred stock, they typically comprise up to 10% of balance sheets. Imperial says Public Storage (PSA) is the REIT preferred sector bellwether, by far the largest issuer of preferred stock with over $3 billion of issues at liquidation preference, some 3 times or so larger than other big preferred issuers such as Health Care REIT (HCN), Kimco Realty (KIM), and PS Business Parks (PSB). Other large recent issuers include Realty Income Corp. (O).

Based on its universe of 84 of the larger issues from 47 issuers, Imperial says the average yield on the REIT preferred stocks is 7.2%, while the current yield on the NAREIT (common) equity index is 3.6%.

Imperial offers a handy list of pros and cons of investing in REIT preferred stocks. First, the pros:

Dividend yield. REIT preferred dividend yields generally exceed the dividend yield on the common stock from the same issuer. Their preferential status affords greater certainty to the preferred dividends.

Property an inflation hedge. Property income is believed to rise over time at a rate approximately comparable to inflation. Though most preferred stocks pay fixed dividends, an increase in REIT income should improve credit metrics.

REITs survived the recession in generally good shape. Since the beginning of 2010, REITs have raised approximately $125bn through the public markets involving common and preferred stock and unsecured debt, which has improved their financial position.

Modest leverage. Among leading REITs, leverage is around 35% with 2.8x interest coverage. An increase in REIT cash flow should improve debt/interest coverage ratios.

Hedge/diversifier versus common stock. An investor might own common and preferred stock in the same issuer to blend different risk/reward characteristics. Imperial says common stock should outperform during a period of rising optimism and preferred stocks should outperform a weak environment.

And the cons:

Vulnerable to rising rates. The price of preferred stocks as fixed income instruments would be vulnerable to raising interest rates.

Call and reinvestment risk. Most REIT preferred stocks are callable in whole or in part by the issuer five years after issue and anytime thereafter. This exposes investors to reinvestment risk should an issuer choose to redeem preferred stock.

Limited secondary market liquidity. It can be difficult to invest sizeable amounts speedily and to liquidate large positions.

Dividend Attractiveness. Preferred stock dividend yields can become less attractive compared to common stock dividends. The REIT rules dictate that REITs must pay out a minimum of 90% of their taxable income. As their income increases, REITs will generally move up their common dividend payments while the preferred stock payments remain fixed.